Sunday, February 13, 2011

I have a friend with a fair career as an analyst in Asian private equity funds. He describes the central debate as being between the “Guanxi guy” and the “Analyst guy” (in his world they are mostly guys) and he says the “Guanxi guy” has won almost all of the battles.

At Private Equity (PE) firms the debate as to which deals to do and what price to pay has been between the Analyst guys and the Guanxi guys - and with the Guanxi guys winning almost every time. Analysts - when they have reservations about deals - are seldom heeded.

Some analysts - not wishing to besmirch their reputation with bad deals done for the wrong reasons struck out and started their own small private equity funds. When they find the deals they try to fund them and discover that the banks (or their Guanxi connections) want to take a piece of the equity. I guess that is the price of doing business. But even after paying up they find the banks want to charge them over-the-odds for funding.

So the deal goes to some Guanxi guy - and the banks queue up to do the funding at low spreads. (Whatever you say Sir says the banker...)

And so - in the great Guanxi vs Analyst debate Guanxi repeatedly wins.

Guanxi is less important in the West - but connections remain important. The definitive Western Guanxi firm is Carlyle. Carlyle is a private equity firm known for employing senior political figures and using those connections to win deals - but also for their knowledge of how government functions. The list of famous employees is large and include:

Carlyle is conspiracy theorist's dream because with all of those famous and well connected people the company understandably has important and profitable investments in the defence establishment.

But in Carlyle’s defence - many of these people not only bring connections but they bring knowledge and understanding of what is important to government and the defence establishment. The first President Bush for instance was also the CIA director - he almost certainly knows what is important to the CIA and how to sell stuff to them - and he would know that without exploiting any connections. These people are hired for the connections and for their knowledge.

Carlyle has taken this way of doing business to Asia and has hired many important and well connected people in Asia. I listed a former Phillipine President and a former Thai Prime Minister. There are many more of these people in China - notably the children of party officials.

Alas I think Carlyle’s business model in Asia is fundamentally flawed: we can see this through a purely hypothetical example.

Imagine if Chelsea Clinton went to work in business and to sell her connections. (I know nothing about Chelsea Clinton other than she got married recently - so this example is purely hypothetical.) And suppose that with considerable hard work at some Wall Street or Private Equity shop she wound up with $5 million. (As I said I know nothing much about Chelsea.) We would not be terribly surprised if Chelsea wound up with $5 million - we might think it unseemly - but it would also by Western standards not be terribly surprising.

However if Chelsea - through nothing other than her connections - were to wind up with (say) $500 million then that would be unseemly. Journalists would be all over the story and the integrity and morality of the people involved would be questioned. Indeed it would be so unseemly it would not happen.

There is a line here - $5 million is sort-of-OK. $500 million is clearly not. I suspect the line is at high single-digit or low double digit millions. Obviously the line is higher for a President than it is for a President’s daughter. Whatever: the social sanction matters.* The cynics would argue that there is a socially acceptable amount of looting. I prefer to think that wages - particularly of people who sell their “Guanxi” are socially conditioned.

That social sanction is considerably different in Asia. There are several “Princelings” in China (children of party officials) who have made hundreds of millions of dollars (or more). Suharto in Indonesia complained that that which the high-and-mighty in Washington thought of as “corruption” he saw as “family values”.

And thus we see Carlyle’s problem in Asia. In the United States the Guanxi guys will work for single-digit millions annually and think they are well paid. That is all they are entitled to. Such limitations on entitlement do not exist in Asia - and the Guanxi guys are likely to see Western funded private equity shops like Carlyle as piggy banks to loot. Sometimes they will be looted by the Guanxi staff but more likely they will be looted by Guanxi connections of of the Private Equity shop's Guanxi staff. And the looting will not be a million or two dollars here and there - it will be for every penny they can extract. The losses could be enormous.

To this end I present to you China Forestry. China Forestry was a billion USD Hong Kong listed Chinese company with many Private Equity funds having stakes. The leading stakeholder is Carlyle (or more precisely funds belonging to Carlyle’s clients). The stock has been suspended after admitting “accounting irregularities”. But it is worse than that.

China Forestry had a business model which consisted of fast-growth forestry to extract greenhouse gas credits - a business model that barely made sense to some analyst guys that looked at it. However it was a business model that made sense if the company had enough Guanxi - enough connections to extract a really bad (ie nonsensical) deal from the Chinese government. And the holders of China Forestry to some degree believed just that. They believed in the Chinese Guanxi. And implicitly they believed the deals were being bought to them by the Guanxi of their staff.

Now China Forestry remains suspended. No reasonable questions are being answered - so I am going to reveal to you the Analyst gossip: the bulk of the forests do not exist. Sure they had some “front” - plantations they would take potential investors to. But the vast bulk of the business was a fiction and “accounting irregularities” is code for “fiction”.

Oh - and Carlyle has dusted 105 million dollars.

If this is fraud then Carlyle has a little egg on their face. After all - what is the point of having all those investment professionals if they get dusted by the simplest of frauds. The whole point of private equity is that by pooling capital you can get insider positions and you can run the company for cash - for the benefit of your investors. But if your “insider position” doesn’t even allow you to spot the business does not exist then your insider status is worthless. You might as well close up and go home. You have no right to be in business.

This blog has been detailing another stuff-up of Carlyle. I am short China Agritech - a company listed on the NASDAQ with operations in China. At least the operations are meant to be in China but after considerable looking (only part of which has been detailed on this blog) we cannot find any convincing evidence that the bulk of the operations exist. In this case Carlyle is the biggest investor and has exercised its right to appoint a board member. Again it looks like they have been dusted.

The analyst guys are cock-a-hoop. They think that now the great Analyst-Guanxi debate will now - at least sometimes - be resolved in their favour. I think that is optimistic - this sort of “network capitalism” is too entrenched for a few stuff ups to upset. What is required to blow this apart is a collapse of the entire network.

Only after the collapse of network capitalism will the system be cleaned up and capital be allocated on the basis of analysis rather than connections. Whilst I am only nominally an Austrian economist - there is a long empirical history that this sort of stuff lasts until it doesn’t - until it has its “Minsky Moment” and only then is it replaced by something more sensible.**

So - on the basis that the system really is entirely stuffed up - and a blogger in Australia can find the empirical evidence for that stuff up I am predicting the collapse of the Asian Private Equity business. And Carlyle - the most Guanxi of all firms - will be the centre of that collapse.

John

Note 1: The other investment in Asia I am following which - at least on my analysis - barely exists - is China Media Express. CCME has been the subject of a few blog posts - but the main argument for the veracity of the company is the investment by Starr Asia. Starr is Hank Greenberg (ex AIG). Hank has more Guanxi than any other Westerner in China. He is an impressive man. However I suspect he has been done by his Guanxi here too.

*Note 2: Chelsea Clinton did work for Avenue Capital Group (a hedge fund and private equity group). However this has been entirely without scandal. In the West it usually is without scandal.

**Note 3: It is entirely possible that post-scandal the capital will be allocated according to the time-honored Asian tradition - stick the losses to the foreigners and the profits to the guys with Guanxi. (See Asia Pulp and Paper or GITIC for examples.)

26 comments:

We can only hope people start casting an eye to some of the more ridiculous blowups and crappy performance in the PE space in Asia. Many of these guys are out raising money right now having realized very little (notable exception: TPG's sale of Shenzhen Development Bank) and their recent portfolios are pretty choc full of turds. The idea that this space is better risk reward than liquid markets stuff out here is laughable. They are invariably on the mid cap bull market growth trade with no downside protection. You know what? If you want that story go out and buy some Yurun, Want Want and some Bank Central Asia. Congrats - now you get the same returns more or less with liquidity and without paying your hard earned dollars out to princelings and the banking analysts that were too stupid to get a gig at a hedge fund but looked good enough in a suit to bamboozle fund of funds that they know what they are doing.

It seems to me that the collapse of Guanxi-based Asian PE, along with perhaps one or two or more listed firms, will come in part from a thorough investigative review of the Financials of these listed companies. Dr. Al Rosen has written extensively on "liberal" accounting to goose up results. You can find some of his work on web. He also has written a book entited "Swindlers".It's easy to slap a sign on the door and call it a "facility" if pressed, make excuses as to why it not busy "at the moment". But inflated revenues, upon which the share price is based, coupled with inflated expenses and fixed assets purchases (otherwise the cash flows into the bank which is an easy check) can't have signs slapped on them.

Is it true that China, a year or 2 ago, has allowed shorting of stocks?

Given the amount of fraud, this seemed like a great environment for native Chinese short sellers to feast on.

What is holding these people back? Is it the political environment? Is it the double digit growth rate? Why are short sellers affective in the west but not affective to the same degree in China?

China hasn't had a big down turn for a while. Events like the great recession is hugely cleansing in the west. However, the impact in China is relatively short. Any thoughts on where things will first show signs of cracking?

There are two Chinese reverse merger stocks that are currently in the subject of buy-out offers.

In one case, On Nov 3, 2010 FSIN (fka PLLK) announced that it's CEO, Mr. Li Fu along with Abax, a HK firm, were going to buy the company at $11.50 a share in cash. Over three months later there are still no filed deal documents.

In another case, HRBN (fka TESV) announced a deal on October 11, 2010 where the CEO along with Baring Private Equity was to buy the company at $24.00 per share in cash. As of today there have still been no filings in regards to that deal. However, Abax's name shows up prominently in HRBN as well.

If memory serves, I recall reading that Chelsea's mother did rather well during her first year trading commodities. Dollar gains didn't pass your threshold, but rate of return seemed rather astonishing. I've always wondered how the other clients of that trading firm fared that year.

Back to Guanxi again!The Wiki article I fear is not correct.http://blog.chinesehour.com/?p=1057 and comments is a little better.The article sort of views guanxi as a Mafia type obligation. Which is wrong.That is an obligation of one individual to another.

But if I understand correctly, in the areas where Confucius resonates with the underlying social system, there is no such thing as an individual ego containing an individual soul.Rather you ARE as a member of a group. Recently scientists were surprised when they learned that certain bacteria in times of stress would stop swimming around separately. Instead they glommed together into a single stalk and some were sent out spores. Notice how projective this is. The natural state is seen as free swimming.Only in time of trouble do the parts get together.Perhaps an NW Asian might see that the stalk is the primary state of bacteria being and in times of plenty, it desolves into individual cells who can better multiply.And strengthen the stalk when the environment goes south.

This is one of the most important articles I have seen on corruption in China, and it puts the whole issue into a different scale of understanding for me.

John, do you think a retail investor can trust any Chinese issue given the mind boggling level of corruption in this country? If government officials feel entitled to hundreds of millions of dollars of corrupt payouts, and that corruption gets reflected in many of the businesses throughout the country, then clearly no one should believe any filing made by any Chinese company, because the corruption is systemic and at a level that Westerners cannot quickly comprehend. We are in effect trying to project the level of corruption in Western businesses, and our tolerances toward this, onto China, and China is just practicing all of this black art at a much different scale than Westerners understand.

It's not so simple as the Foreign Corrupt Practices act, because Carlyle isn't bribing anyone directly. They might have been offered a pool of deals without a lot of words exchanged about the fact that two of those were Turkeys.

Carlyle could have put up with the bad deals without understanding the details of the corruption within them. But the important point would be that Carlyle's presence in such a deal wouldn't necessarily indicate that they did due diligence, or that they even like the investment.

TPG has had several problems in its China portfolio, including in Shanghai in which they were locked out of the offices by the local management. Blue Ridge Capital's China fund has had at least two major frauds--ITAT and Gushan. The list is not short, but they seem to have enough big winners to make up for the frauds and turkeys. Cost of doing business in China?

See this article from China Daily in 2008:PE: Behind so many failed projects that have 'fool-you'edhttp://www.chinadaily.com.cn/bizchina/2009-03/06/content_7548700.htm

"In recent years, many mediocre companies and short-lived commercial myths have been the target of round after round of investment by foreign parties. Bad projects fetched skyrocketing prices as China's red-hot VC/PE market blew big bubbles.

Looking deeper, it is not difficult to see that one of the main culprits is the "fool-you" culture of this industry. For example, some general partners (GP) of foreign PE funds abandon the primary goal of finding good projects to get high returns and don't wait until the end of their investment tenure to cash in their bonuses. Instead, they have tried their best to legally take money out of the pockets of foreign investors and then change jobs. The final victims are invariably the limited partners of these foreign funds, who have to write off the investment losses.

A Chain of Grey Interests

The manager at a famous foreign fund says 70 percent of its projects come from "middlemen", or individuals rather than institutions. Why do these GPs need so many such "middlemen"?

One local fund manager explained: "If I follow up a project and it is nearly ready, I would tell my investment committee that this project was introduced to me by another manager who works for another fund. I would get a finder's fee, which I will share with the other manager. The other manager will do the same to me with his projects. We both have legitimate income."

To prevent such practices, some foreign funds prohibited a "finder's fee" or "introduction fee". That proved little problem for the greedy GPs. "The fees can be paid by the target company to a related person designated by the GP. This is allowed and has no direct link with the fund," the manager said. "But the fund has to pay for it one way or another. Also, in some cases, an investment fund can buy out a company at four times P/E. But the GP talked the fund into paying five times P/E. The extra amount will be shared between the target company and the GP." In this chain of grey interests, there is inevitably the real "intermediary", the investment banks. With their expertise in packaging the projects, investment banks added a formidable force in pushing a quick investment decision by the funds.

One's Own Fund Is a Better Place to Earn Money Than a Good Project

If cheating funds with a "finder's fee" is a practice limited to a few managers, the most commonplace practice to rip off investment funds is to invest as much as possible within the provided time frame and skip the necessary project investigation and review work and the hard bargaining of purchase price..."

guanxi means more than connection....it is, in many cases,about a deal without contract but sort of mutual trust.

when without contract, the deal must be vague and contains both reward and risks...reward may bring you 10X return and risks may cause you a heart attack.

Remember, when someone shops you a Guanxi or himself as the Guanxi, you need to spend enough time to investigate that "Guanxi"...in many cases, an important guy's driver is more powerful than that guy's right hand man, simply because the driver knows too much.

"In the United States the Guanxi guys will work for single-digit millions annually and think they are well paid. That is all they are entitled to. Such limitations on entitlement do not exist in Asia - and the Guanxi guys are likely to see Western funded private equity shops like Carlyle as piggy banks to loot."

I think this is one hell of an accurate and elegant way to put a good yet somewhy not very widespread insight.

(Same here in Russia, and I've been trying to explain the effect - if to myself - in comparably elegant way for quite some time)

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The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.